The general feeling on the Roth IRA is that the money grows tax free. When you are ready to withdraw the money, you do so without paying taxes. While this is true in a number of cases, the reality is far less cut and dry. There are times when you will pay taxes on your Roth IRA withdrawal, and it’s important to understand when those times are.
Because there are a number of interesting benefits related to the Roth IRA, it is little surprise that there are also a few rules that you need to observe in order to avoid taxes. Here are some instances when you will pay taxes on your Roth IRA withdrawal:
You are Under 59 1/2
The first instance is if you are under 59 1/2. It’s true that you can withdraw your contributions at any time, no matter how old you are, tax free. However, once you start withdrawing earnings, the story changes. If you aren’t 59 1/2, and you withdraw earnings (except in specific cases, including disability, that are listed on page 64 of IRS Publication 590), you will pay income taxes on that money. On top of that, you will also be levied a 10% tax penalty by the IRS.
So, let’s say I contribute $3,000 each year to my Roth IRA. After two years, my account contains $6,500. I decide that I need a little extra money to take care of an unexpected expenses. I am 33. So, if I want to withdraw money, I can withdraw up to $6,000 without pay taxes, because that is how much I put in over the course of the two years. However, if I
withdraw more than $6,000, the amount beyond that will be taxed — and I’ll have to pay a 10% penalty on top of that.
You Have Had Your Account Less than 5 Years
Another rule of the Roth IRA is that you can’t start withdrawing earnings without penalty until you have had the account for 5 years — and it doesn’t matter how old you are. Let’s say you’re 58. You open a Roth IRA, and contribute $5,500. For the next few years, you contribute that amount of money. So, after four years of contributions, you have $22,000 in contributions, plus another $3,000 in earnings, for a total of $25,000. Even though you are now 62, and beyond the 59 1/2 milestone, you haven’t had your Roth IRA for at least 5 years. This means that if you withdraw more than $22,000, you will be subject to income tax on the money. However, since you are beyond age 59 1/2, you don’t have to pay the 10% penalty.
If you are rolling over a tax deferred account to a Roth IRA, you will have to pay taxes on that money, since it hasn’t been taxed yet. Realize, though, that it becomes subject to the five year rule at this time, no matter how long you have had your Roth open. If you withdraw the money before you are 59 1/2, you will have to pay a 10% penalty, even if the money is considered a “contribution,” and it has been less than 5 years.
If you have questions about when your Roth IRA withdrawals are taxed, and when they are not, consider consulting with a tax professional.